PrintJanuary 30, 2010
Obama Turns On the N.Y. Banks
After getting soundly pummeled three elections in a row, President Obama has aimed his bully pulpit at the bankers of Wall Street. What better target when the nation is hurting financially? Most of the banking world is so abstruse that Obama can use simple rhetoric to make his point and win the debate. With the backing of former Federal Reserve Chair Paul Volcker, President Obama proposed a ban on proprietary trading by Wall Street investment banks. However, as is the custom of our president, the words he utters are quite different from the policy that will come from them.
Obama is targeting the proprietary activities where banks invest in private equity and hedge funds. He is not going after the real area where banks rig the market: the proprietary trading activities where they use their capital to trade against their own customers in the marketplace. Less than 10% of the banks' profit comes from the activities Obama is targeting. The policy switch Obama is proposing will do nothing to prevent another meltdown. He is using a peashooter while giving the impression of using a cannon.
If this proposal were designed to change the way financial institutions interact with markets and make both work better for the American people, Obama would target the anti-competitive proprietary trading cartels. The president would make regulatory changes based on function and not structure. Bills that have come out of the Barney Frank-Chris Dodd committees in the House and Senate simply add another layer of bureaucracy and do nothing to prevent another financial meltdown.
Functional regulation takes into account the role an entity plays in the marketplace. A publicly traded company like Goldman Sachs should be held to higher and different standards when compared to a privately held one, like Citadel. Functional regulation would eliminate conflicts of interest. Banks would no longer be allowed to engage in dual trade. Customer orders would be brought to a public marketplace to be transacted, not internalized to a back office or shoved into a dark pool of liquidity. Goldman Sachs even sent out a letter to their customers apologizing for the practice. Functional regulation would force markets to be more transparent.
Today, a large percentage of financial trading takes place away from the broad markets like the NYSE. Banks try to keep as much information away from the market as they can so that their proprietary trading desks can use it to their advantage. The general public gets taken for a ride every time they submit an order. So do a lot of the big mutual funds the public and pension funds invest in.
The banks did a gross disservice to customers by selling them packages of junk. But they really damaged the market by the way they traded in the unregulated over-the-counter (OTC) marketplace. The resulting market was so muddled that none of the counter-parties knew who was holding the bag, or even who owed whom money. AIG was the dumping ground for Goldman and others, and it carried the lion's share of OTC risk on its books. This kept risk profiles away from the eyes of any regulators. More importantly, AIG shielded the broader market from imposing any "invisible hand" market discipline. In the aftermath, Treasury Secretary Tim Geithner saw fit to repay the big OTC players 100% of their losses from AIG. This increases the likelihood of a repeat disaster. So the chance of another debacle has increased, not decreased, in the last year.
Does the government have the intestinal fortitude to actually do something about the problem? Government needs to be smarter with the tools it already has. Currently, agencies like the SEC use antique structural regulation that doesn't work. All it would take is a direct order to change the way they look at things and rewrite current regulation accordingly.
It is hard to comprehend what happens in the marketplace if you are a novice. Imagine yourself at a poker table. You are able to see all the cards, and you know how much money all of the players have to wager. You can see the cards in the deck that are about to be dealt. There isn't a lot that you don't know. Plus, you also own the house and the dealer, and you are actively playing in the game. With all this information, it would be virtually impossible to lose money. That's what a big bank does with its proprietary trading. It rarely if ever loses money. As every experienced trader knows, it is virtually impossible to increase trading profits every year. Profits are variable and volatile.
What has changed in our financial system since the Long Term Capital Management debacle in 1998? Banks that were private have gone public. The world financial system is more interconnected. Capitalism has brought new and growing international economic powers. But on the regulatory side, much has gone unchanged. The Glass-Steagall Act was repealed, but just reenacting it is too simplistic and the wrong regulatory approach. Bringing the act back would simply separate some functions, but it wouldn't do anything to make the underlying marketplace more transparent or competitive.
Reenactment wouldn't free up markets to utilize internal checks and balances. Plus, it was designed for a banking industry in 1930, not 2010.
It is important to understand why we had a financial disaster. The meltdown has its roots in Federal Reserve Policy and policy with regard to Fannie Mae and Freddie Mac. Alt-A and subprime loans from 2001-2007 escalated in percentage of the real estate loan market from less than 10% to close to 36% of the market. The N.Y. banks took advantage of this largess and sold to their own customers packages rated AAA that were really subprime, low-grade debt. Meanwhile, the private ratings agencies didn't do their homework and rated the products incorrectly. Bank customers didn't undertake necessary due diligence before investing money in the risky packages. The perfect storm for a financial meltdown came together. Neither Obama nor the related congressional committees have proposed anything that would not stop this from occurring again.
Obama is correct in proposing an end to "proprietary trading." If he targets the type of proprietary trading that bleeds the marketplace of information and order flow and exponentially increases market risk, he is hunting in the right field. Currently, though, Obama is paying lip service to real change and highlighting bank investments in hedge funds, venture capital, and private equity. Regulation in these areas will only make things tougher on the general public.
If the administration continues down this path, nothing will change. More bubbles will occur, and a boom-and-bust economic cycle will resume. Boom-and-bust has been in place since the late 1990s, but the steady growth cycle from 1983-1996 is preferable. No matter which political horse you ride, you should be indignant about what happened and the reaction to it. Without properly functioning transparent competitive markets, the economic environment in America will continue to limp along.
